Des opportunités outre-manche ?

8 novembre 2019

Chris Iggo , CIO Core Investments

Key points:

Lost-growth

Some fiscal boost

No bond shock

Equities have underperformed

Sentiment could turn

Bounce

Putting Brexit to bed in 2020?

There are potential opportunities in UK equities. However, these are dependent on the post-election and post-Brexit environment. Companies and investors remain concerned about the risks of a Labour government and a disorderly Brexit, both of which could be disruptive to business and lead to further disinvestment from UK assets. A clear election result on December 12th and rapid progress towards an agreed, extended, transition period would boost confidence in the UK. The valuation of UK equities relative to fixed income, the lack of any expected rates or credit shocks and the under-ownership of the UK market and UK stocks, could generate conditions for a significant improvement in relative returns.

Lost-growth

Uncertainty over Brexit and the broader political outlook has impacted on UK GDP growth since the June 2016 referendum. This has largely been through the reduction in capital spending. Starting from Q3 2016, UK growth has lagged the US by some 3.5 percentage points and is some way behind many European economies, including France and Spain. Expectations for some recovery in growth are very dependent on what happens on the political front in the next few weeks. It is likely that a Conservative majority after the election would allow for rapid parliamentary agreement of the Withdrawal Act and a UK exit from the EU on January 31st. Consequent to that, the UK would enter negotiations on a free-trade agreement and the new government would need to ask the EU for an extension to the negotiating period that would extend this by another 12 to 24 months. This would allow UK companies plenty of time to prepare for the new trade regime, and to start becoming aligned to any new international trade agreements the UK would be in the process of negotiating. Such an outcome could see some increase in capital spending as companies make up, to some extent, for the lack of investment in recent years. However, the scale of this depends on a number of things, not least of which will be the state of the global economy in the next two years. Nevertheless, we would expect that business confidence would certainly be stronger than it has been. The strong bull case is that the UK and EU agree on a tariff free trading agreement with not much disruption to regulatory alignment.

Some fiscal boost

The other key part of the macro outlook will be what happens to fiscal policy. Spending is likely to increase under most election scenarios. At the moment it looks as though this will be biased towards consumption (increased hiring in public services, some extra funding for the NHS) and not on large capital projects (although there may be some climate related spending). Nevertheless, there will be some fiscal stimulus which will add to growth. The government has already said it will change the fiscal rules in the UK and this will allow capital spending to rise as a percentage of GDP. It is important to keep in mind that unemployment is low and job creation has been reasonably strong, this should remain the case given the promises to hire more police and increase spending in the health service. Low interest rates also remain a positive for the outlook. Promises made during election campaigns should clearly be taken with a pinch of salt, but the spending plans rolled out by the two large parties over the last week confirm that the years of austerity in the UK are over. Spending and borrowing will increase in the years ahead.

No bond shock

More government borrowing should mean marginally higher bond yields. However, this is likely to be a medium-term trend. In the short-term, gilt yields will be influenced more by what is happening on the global stage. The improved prospects of a trade deal between the US and China has already pushed yields higher in developed bond markets. This could continue into next year as central bank interventions provoke a new “reflationary” cycle. However, there is a limit to how high bond yields can go when monetary policy is anchored at very low interest rates. Even if Treasury yields go higher, strong demand for bonds with a positive yield would likely see global flows capping the move. For gilts, the actions of the Bank of England will also be important. At this week’s monetary policy meeting, two members voted for a rate cut amid concerns about the global outlook and the risk that some of the negativity around Brexit could become entrenched in the UK outlook. While this does not mean rates will be cut, the barrier for rate hikes is quite substantial and requires much more clarity on the post-election, post-Brexit outlook. Gilt yields above 1% would be quite attractive relative to European government bonds. Lastly, a sustained rise in bond yields needs more than just a Trump-Xi handshake. It needs global data to get better.

Equities have underperformed

Since the referendum, UK equities have underperformed other major equity markets. This is evident this year too. The FTSE-100 index has managed only half the price return of the Dow Jones and less than half the price performance of the S&P500 and the Eurostoxx 50. Small and mid-cap indices have fared better, but the general feeling is that UK equities have underperformed. They are also under-owned. Moreover, the yield gap between UK equities and gilts has widened significantly in the favour of stocks. Gilt yields have been dragged lower by low interest rates and global quantitative easing, while the market dividend yield has actually risen in recent years. While high dividend payers are not necessarily the most attractive part of the UK equity market, the point is that stocks in general have cheapened on a relative basis to bonds. This is certainly more than in other major markets. We do not see much scope for gilts to cheapen significantly in the months ahead, but there is clearly scope for the relative valuation of equities and bonds to move. Of course, uncertainty in the political outlook leads to weak sentiment about the corporate and economic outlook. This, in turn, has encouraged investors to reduce exposure to UK assets. Even though we would argue that equities are relatively good value, the 12-month growth outlook for corporate earnings is much weaker for the UK than for the US or continental Europe.

Sentiment could turn

The UK has been out of favour. However, in a sign of how things could quickly change, note how strongly the currency rallied when Boris Johnson announced that his government had reached a deal with the EU. Domestic sentiment has been held back by uncertainty over Brexit for some time but the prospect of a Labour government, crystalized by the announcement of the general election on December 12th, is also an issue. These concerns stem from the risk of higher income and corporate taxes and an ambitious nationalisation programme. While opinion polls suggest that the chances of an outright Labour majority are slim, the uncertainty around the British political scene at the moment means that these concerns won’t be put to bed until the election result is clear. Even then, there is a scenario that could include Labour in government as part of an alliance or government of national unity. Given the many moving parts in the upcoming general election – Leave or Remain, Scottish independence, more polarisation between the two largest parties – most investors are unlikely to commit to a more bullish view on the UK until early next year.

Bounce

It is noted that the large-cap part of the UK market has tended to react perversely in relative terms to bad Brexit news and a weaker pound. This is because many companies in the top-100 are significant foreign earners that benefit when the exchange rate is lower. However, elsewhere we think there is value in small and mid-cap companies that will adapt to any new trade agreement with the EU as long as the outlook is more certain. Dividend growth may continue to struggle as a strategy – given concerns around the oil price and the business models of some of the other large cap dividend payers – but even here we could see a post-election bounce. There has been little evidence of the longer-term trend of disinvestment from UK equities reversing, but recent M&A activity and reports of more speculative investors building up positions for a post-election bounce are positive. If other investors share our belief that the UK market is ripe for a period of better performance, then a self-sustaining rally in the market could be seen, accompanied by asset allocation flows into UK equities. For UK credit the outlook is stable. Our view of corporate borrowers is that they have been cautious with balance sheets while demand for good quality corporate bonds remains extremely strong. The ongoing de-risking of defined benefit pension funds is part of this strong institutional demand for credit. The fact that spreads have stayed stable is also consistent with a more positive equity environment.

Putting Brexit to bed in 2020?

Brexit has been a blight on political discourse, consumer confidence, the economy and UK markets for long enough. While there has never been too many obvious Brexit-trades, today there is certainly a case to be made for a recovery in UK equity performance and a strong pound. Yet, it is understandable if there is scepticism around such an idea. After all, politics has become more fractured in the UK and the election is hard to call. There hasn’t been a winter election in most people’s lifetimes and there has never been an election like this one where the Union’s stability is at stake as well as the relationship with the European Union. There is a pessimistic outcome too. The Labour Party is not business friendly. A hung parliament would extend the uncertainty around Brexit. It is also important to keep in mind that should the Withdrawal Bill get passed, there will still be a lot to agree on regarding the future relationship with the EU. While the immediate danger of a “no-deal” will have diminished, it won’t have disappeared completely. There could be more disinvestment from the UK as a result, with consequences for jobs and growth. But with a clear result in the election and a mutually acceptable Brexit deal, there should be a bounce.

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